Investing In A Franchise Business

Franchising is big business in Australia with estimated sales of around $144 billion per annum. According to a 2014 report from Franchising Australia there are more than 79,000 franchisees operating in Australia and they employ more than 460,000 people. The perception is, buying a franchise is safe and it’s almost a cash cow. Recent media reports suggest this may not be the case and make no mistake, franchises do fail.

For example, Wendy’s Supa Sundaes, the former master franchisor of the ice cream and hot dog chain was placed in voluntary administration in July 2015. In late November 2014 Pie Face, the Australian fast-food chain appointed administrators. Several years ago, the eight year old franchise, Refund Home Loans collapsed with around 350 franchises. The notion that buying a franchise is a ‘safe’ investment is history.

Franchising is now across most industry sectors from fast food to real estate agencies, signage manufacturing, gymnasiums and even accounting firms. The attraction is often the belief that buying a franchise is like buying a ‘business in a box’. You are basically buying someone else’s business or brand together with all their systems, processes and marketing collateral. It sounds like a recipe for success but before you invest in a franchise you need to do your homework. In the due diligence process you might find the systems and training offered by the franchisor are inadequate, the location is unsuitable or there is no real marketing plan behind the business. Be careful, your research might reveal the fact that the market is saturated and the frozen yoghurt industry is a great example. In the last 18 months we have seen a flood of frozen shops melt.

BE SELECTIVE!

We are not suggesting for one moment that buying a franchise isn’t potentially a great investment. There are plenty of success stories but there is also a growing number of franchise casualties. The ‘business in a box’ concept is particularly appealing to first time business owners who are looking to minimise the risk but you need to be very selective about your investment, understand precisely what you are buying and seek professional accounting and legal advice.

This month the 7-Eleven franchise has been rocked by allegations that international students have been underpaid and exploited. A joint investigation between Fairfax and Four Corners suggests that 228 stores, equal to a third of the network, delivered total income to the franchisees of $350,000 or less for the year to June 2015. The report shows one store generated income of less than $150,000, 38 stores earned less than $200,000 and 84 stores earned between $200,000 and $250,000. Under the 7-Eleven model in Australia, head office takes 57 per cent of gross profits from the store, while the franchisee receives 43 per cent of the store takings as ‘income’. Out of their share of the income, the franchisee must cover a number of expenses including wages. When you take into account the fact that 7-Eleven stores are open seven days a week, 24 hours a day throughout the year the wage costs would mean a lot of stores would barely break even. Of course, if the franchisee also borrowed money to buy into the franchise then they could be generating a loss.

A franchise study from 2008 suggested that:

Only 81% of franchisees are profitable

58% of franchisees generate a profit of less than $50,000 per annum

3% of franchisees generate a loss of more than $50,000.

According to a report on food franchising by Franchise Business Review, 51.5 percent of food franchises earn a profit of less than $50,000 a year; roughly 7 percent exceed $250,000 with the average profit for all restaurants coming in at $82,033. That sounds reasonable but when you consider the initial franchise fee of between $500k and $1m for a restaurant it represents a relatively small return on the investment.

On a positive note, the Franchising Australia 2014 report suggests 72 percent of franchisors report that franchisees have recorded increases in revenue over the 2013/2014 financial year. In addition, over two thirds of franchisors believe franchisees have recorded profit growth over the last financial year and over 80 percent of franchisors expect franchisees to record revenue and profit increases in 2014/2015.

THE TRAPS

While some franchisors market their franchise as a ‘turnkey’ operation, running a business requires energy, passion, persistence and commitment. There is no substitute for hard work and if the business was just a profit making machine surely the owner would set up more sites and just employ the staff?

The number one question that a prospective franchisee wants to know is, “How much will I earn?” It’s central to the buying equation and some franchisors now offer income guarantees, particularly in the service franchises including lawn mowing. Given these types of franchises generally attract first-time business owners moving from a salaried employment position the income guarantee can be very appealing. The guarantees are often stated as ‘$1000 a week for the first ten weeks’ to reassure the franchisee and reduce the perceived investment risk.

Other franchisors are offering prospective franchisees a guaranteed income of say $50,000 per annum. This provides the franchisee with a degree of certainty in their first year of trading and can help the franchisee secure finance. While income guarantees might provide short term peace of mind for new franchisees, they expire and buyers need to look beyond income guarantees when evaluating a franchise. What if the operator is not suited to the type of work? What if they have no marketing or people skills? What if a new competitor springs up with improved technology and cheaper prices?

Generally speaking, most people looking to buy a franchise will look at least two different franchises before making a decision. You need to look at the total package including the price, training, equipment, marketing materials, ongoing fees and income guarantees. Don’t make the decision based on one aspect of the package and make sure you understand the terms and conditions of the franchise agreement. The 7-Eleven experience serves as a warning for everyone.

Buying a business doesn’t guarantee financial success and franchises are not immune from risk. Before you invest in a business or franchise we urge you to consult with us. If you are looking to franchise your business you must seek professional advice from franchise experts and we are here to help you.